HEDGE FUNDS

Regulation cometh

It will make trustees feel a lot more comfortable with a strategy that seeks to protect capital in all market conditions, suggests Hedge Fund Academy founder Marilyn Ramplin.

Ramplin...through the opaqueness

Although hedge funds are an enigma to most people, they might nevertheless become unwitting participants through their pension-fund investments.

A key amendment to Regulation 28 of the Pension Funds Act is that pension funds will be able to invest up to 10% of their assets in hedge funds. It’s a notable increase. Previously, hedge fund investments were accommodated in a narrow 2,5% category reserved for “other” investments that included private equity.

There are different schools of thought. Some argue that the amendment will open doors to a potentially lucrative world of investment otherwise inaccessible to smaller investors and, more importantly, an opportunity to achieve diversity in pension funds’ portfolios. If constructed properly, a portfolio of hedge funds can achieve an absolute level of return for a much lower level of risk.

Others have raised concerns that these investments by pension funds are exposing trustees, and subsequently beneficiaries, to risks that may be above and beyond their levels of tolerance. If so, trustees would be in breach of their fiduciary duty.

But consider the possibility that breaches of fiduciary duty may arise not just from malfeasance but also from non-feasance. What if a trustee fails to use a strategy aimed at achieving an absolute level of return for a much lower level of risk, hedging the portfolio against downside risk and protecting the capital?

In today’s environment of increasing regulation, trustees could now not only be accountable for actions that they take but also for actions that they do not take.

The Financial Institutions (Protection of Funds) Act provides that financial institutions – which includes pension funds under the direction of trustees -- are required to observe utmost good faith and exercise proper care and diligence in the exercise of their duties. Trustees who don’t could be liable to various penalties.

Problematic for trustees is that, unlike the case with traditional equity investments, they might not be fully aware of where a hedge fund is invested. In general, there’s a perception of opaqueness and lack of clarity that trustees cannot be certain what’s held in a hedge fund’s underlying portfolio. Monitoring of compliance with a pension fund’s investment mandate is then difficult.

But once SA does regulate hedge funds, investors should have much greater comfort. G20 countries are due to finalise regulations by the end of this year. In SA, the Financial Services Board and other interested parties are setting up a regulatory framework.

This will be will be good for trustees. It will give them much greater clarity on how the money in the funds will be invested and a framework around the safety of pension funds’ assets. They’ll feel more confident in using ‘alternative’ strategies to help protect their funds’ capital under all market conditions.

At present in SA, hedge fund managers are regulated by the Financial Advisory & Intermediary Services (FAIS) Act. It provides that they must be approved by the Financial Services Board (FSB) as category IIA discretionary financial-services providers (FSPs).

The code of conduct for administrative and discretionary FSPs, issued under FAIS, includes a chapter on hedge fund managers. The code and FAIS set broad standards of conduct to ensure that FSPs are fit and proper. Also, in 2008, the FSB published a notice on hedge fund FSP risk disclosures.

Slowly but surely, regulation of hedge funds is on its way: all the better for the new Reg 28, and for trustees.